LP Radar: Detroit’s private equity problem

Detroit is the largest city in the US to file for protection under Chapter 9 of the bankruptcy code, and so there are still a lot of unanswered questions – not least around its obligations to keep up with capital calls from GPs

In July, Detroit declared the largest municipal bankruptcy in US history, suffocating under a mountain of debt. What this means for the city’s creditors – including city workers and retirees guaranteed pensions – remains to be seen.
One question among the many related to the city’s Chapter 9 bankruptcy filing (which as of press time hadn’t yet been approved by a bankruptcy judge) was the future of the private equity holdings within its municipal pension funds.

Detroit does not have significant amounts of private equity in its two major pension funds, the $2 billion General Retirement System and the $3.1 billion Police and Fire Retirement System. The systems don’t specifically break out their private equity holdings from other “externally managed” assets, although they do list their holdings.

The General Retirement System, for example, is a limited partner in several funds managed by Wind Point Partners, a Chicago-based firm that invests in the mid-market. Its portfolio also includes LP stakes in Tailwind Capital Partners, Syndicated Communications Ventures, Court Square Capital Partners, Perseus Partners VII, GSC Partners I and II and Falconhead Capital Partners II. 

The Police and Fire Retirement System has many of the same private equity holdings as the General Retirement System, according to both systems’ annual reports for 2011 (the most recent reports available on the website).

PAYING THE PRICE

The question is: what happens to unfunded commitments if Detroit’s Chapter 9 filing is approved? Is the city still on the hook to meet capital calls throughout the bankruptcy process? Kevin Orr, a spokesperson for Detroit’s emerging managers, did not return several phone calls for comment. Nor did the two pension funds.

Unfortunately, there probably isn’t an easy black-or-white answer to this question. First, it depends on whether the pension funds are part of the city bankruptcy; if they are administered by the state, they could fall outside of the city’s filing, according to Theodore Orson, a partner at Orson Brusini. Orson’s firm works as the lead firm for the Chapter 9 process of Central Falls, Rhode Island, which filed for bankruptcy in 2011.

Alternatively, capital call obligations could simply become another “general unsecured claim” against the city “for breach of contract”, Orson told Private Equity International in a recent interview.

GPs have a couple of options when one of their investors goes into Chapter 11 bankruptcy. One is that default interest starts to accrue, as happened in 2009 when Washington Mutual’s holding company filed for bankruptcy. The bank itself was seized by the federal government (and eventually taken over by JP Morgan). But Washington Mutual’s holding company entered bankruptcy protection, shielding it from creditors seizing assets as it worked through its reorganisation. 

In October 2008, WaMu defaulted on a $700,000 capital call to Financial Technology Ventures III. The holding company had committed $10 million to the fund in March 2007, and had contributed up to $3.3 million. As a result of not fulfilling the capital call, the holding company was being penalised with an 18 percent default interest accrual, according to bankruptcy court documents at the time. Further default would have resulted in the holding company forfeiting 25 percent and then 50 percent of its contributed capital as of certain future dates, the documents stated.
WaMu avoided this outcome by quickly bundling its LP commitments together and selling them off, thus getting rid of its capital call obligations altogether.  

Forcing an LP to forfeit already-made contributions is perhaps the toughest measure a GP can take against a default, according to one IR professional (who spoke with PEI on condition of anonymity). In fact, most GPs will probably choose not to go down this road, for fear of looking draconian in front of other LPs. 

LOOKING FORWARD

The challenge for a GP in situations like this is to find replacement investors to fulfill any obligations that are not going to be met. As always, the ease of this process will depend on the performance of the fund. If it’s doing well, other LPs will be glad to step in; if it’s not, it will be much more difficult. 

As for Detroit, it’s important that it does all it can to meet its commitment obligations. At some point, the city will complete its restructuring – after which it will have to get back into the business of funding its liabilities to retirees. Private equity can play a big role in making sure that happens. 

And for similar reasons, it’s important that the inevitable cuts to the public payroll that happen as part of the Chapter 11 process don’t denude the programme of its best talent. Politically, it’s a lot easier to fire a fund manager than a policeman – but for the city to have any hope of keeping its returns at a level that will cover its future liabilities, it needs to retain its best investment talent, and the relationships they have built up over an extended period. Not to do so would ultimately be short-sighted and self-defeating.